Minyan Mailbag - Nightmare Hedges

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Note: Our goal in Minyanville is to remove intimidation from the financial markets and encourage an interactive dialogue among the Minyanship. We share this next discussion with that very intent.

Dear John,

Thanks for writing great columns.

The GSEs and Mortgage Bankers have been some of my best performing shorts lately. These companies have taken on tremendous risk, and appear to mistakenly think they've hedged most of it away. Countrywide (CFC) blamed poorly performing hedges for part of their most recent earnings miss, and OFHEO informed Fannie Mae (FNM) that they'll need to report $9 Billion in derivatives losses. So far the interest rate action during the latest Fed tightening cycle has not been treating these groups kindly.

Here are some questions I have for you, the derivatives guru:

Could you give a brief description of how these companies try to hedge against the risk of rising long term interest rates?

Is it possible to calculate (based on implied volatilities, risk premiums, or some other measure) a maximum rate of increase in interest rates that would render these hedging strategies worthless while still imposing maximum pain and suffering on these companies?

If long term rates were to rise too rapidly, which types of players would be hurt first and/or the most?

How much strain do you think the derivatives market takes? In other words, how fast a rise in interest rates would cause a critical level of failures among the underwriters of interest rate derivatives?

How would we measure and observe changing derivatives market conditions where the cost of insurance (hedges) against rising rates was becoming much more expensive for companies like Fannie Mae and Countrywide?

I ask these questions expecting that the dollar will fall and long term rates will rise, as global trade imbalances are unwound, but that nothing will happen fast enough to put the derivatives biggest and most influential players in danger of significant losses. So far rates have risen slowly from their bottom in October. If they are going to rise more rapidly, I'd hypothesize that we'd see an increase in the effective cost of hedges against rising rates and a falling dollar.

Thanks,Minyan Rodg

Rodg,

The GSEs borrow money at a fixed rate in the bond market at a market rate (a rate that many have called artificially too low caused by an implicit government guarantee that may or may not actually be there) and essentially lend it back out by buying packaged mortgages from banks and mortgage companies around the country. The problem is that the mortgages are not really fixed rate lending (even if the mortgage is fixed) because as interest rates fall, homeowners refinance (pay-off the old mortgage). This leaves the GSE with a liability but no asset; this is called an asset-liability mis-match or duration risk.

When interest rates fall a certain amount then (no one knows for sure until it happens, so this risk acts like a short option) and refinancing occurs unexpectedly, the GSE must replace this "closed out" asset by buying treasuries. They are buying treasuries in a rising market, thereby they are not locking in as high an interest rate as they should. Conversely when interest rates rise the opposite occurs and they must sell treasuries, this time selling into a declining market and again not a good thing. The more volatile the bond market the more negative buying and selling they must do to re-hedge their duration risk. The GSEs are so big that they often push the bond market around themselves. One large criticism then is that the GSEs are just too big: Greenspan has recommended that the GSEs must cut the size of their portfolios dramatically (by as much as a factor of 10) for this reason.

In order to hedge against shifts in interest rates, GSEs and mortgage companies use interest rate futures, options on futures, interest rate swaps, and options on swaps, and other OTC interest rate structures. The use of options is an attempt to reduce the negative convexity risk described above. But this comes with a cost: when they buy options it drives up the implied volatilities of options and the actual volatility of treasuries.

If we had intimate detail of all the hedges and the underlying portfolio, then we could come up with a risk profile, but the GSEs are not required to report in such great detail. We do know that the notional value of derivatives (convexity) has sky rocketed over the last five years; we estimate that amount to be as much as $200 trillion, most of which are interest rate derivatives.

GSEs and subprime lenders such as NFI

I think everyone wants to know what that magical level might be, including me. But I do believe that there is a level and a rate at which things would begin to move that would precipitate the necessity to re-hedge violently.

Volatility shifts in option prices should reflect that as well as liquidity shifts, aggressive moves by the Fed to stave off a cascade of negative convexity. We saw this in 1998. Moreover, as the derivatives market is so large, a transmission of risks is likely to cause anomalous behavior across asset classes.

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